IRS Has $80 Billion Coming Its Way: Expectations for Enforcement
September 16, 2022
By Miri Forster
The passage of the Inflation Reduction Act of 2022 (the “Act”) gives $80B of additional funding to the Internal Revenue Service. More than half of the funds ($45.6B) are allocated to IRS enforcement efforts, with the rest to help improve taxpayer services, IRS operations and systems modernization.
Expectations for the Future
Additional funding will allow the IRS to increase its audit activity. Therefore, documentation to support tax return positions and audit-readiness is key.
Here are five areas where taxpayers should expect increased scrutiny going forward:
1. Virtual Currency
The Act specifically allocates a portion of enforcement funding for digital asset monitoring and compliance activities, so future IRS enforcement in this area is a given.
For 2022, the IRS has expanded its focus from virtual currency to all types of digital assets. The new question at the top of the draft Form 1040 for 2022 states the following:
At any time during 2022, did you: (a) receive (as a reward, award or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?
Disclosure of virtual currency is required on the Form 433 series (Collection Information Statements) used by taxpayers to request payments plans from the IRS, and Form 14457 (Voluntary Disclosure Practice Preclearance Request and Application) for participation in the IRS Criminal Investigation’s current voluntary disclosure program. Beginning in 2023, the Infrastructure Act of 2021 requires brokers to issue Forms 1099 in connection with virtual currency transactions.
Limited information on the tax treatment of digital assets is available. The IRS has issued FAQs to assist but FAQs are not law. Guidance concerning virtual currency is also listed on the IRS Priority Guidance Plan. Erin Collins, the National Taxpayer Advocate, advises taxpayers to proceed with reasonable care, summarizing the enforcement landscape related to virtual currency as follows:
“[T]axpayers should be aware that the IRS continues to focus on virtual currency gains to determine whether systematic underreporting is occurring, and if so, to commence enforcement actions related to virtual currency tax fraud. Taxpayers, institutions, and entities should familiarize themselves with the complexities of the tax and financial reporting rules and understand the reporting obligations when undertaking virtual currency transactions. Failure to do so could result in penalties and other negative consequences that exceed the potential benefits from utilizing virtual currency. Thus, taxpayers should enter this developing realm with due care so as to recognize its benefits while avoiding its pitfalls.” NTA Blog: Wait, When Did This Virtual Currency Question Appear on My 1040 Tax Form (updated April 15, 2022).
Heightened focus on partnership tax compliance continues. The centralized partnership audit regime, generally effective for tax years beginning January 1, 2018, was accompanied by a mandate for increased transparency in partnership tax compliance. Then in 2019, the IRS introduced significant changes to Forms 1065 and Schedules K-1 (Partner’s Share of Income, Deductions, Credit, etc.) including, but not limited to, the requirement that partnerships report tax capital basis. Beginning in 2021, the IRS added Schedules K-2 and K-3 to provide further transparency for partnerships with foreign activities or foreign partners.
The IRS is also actively pursuing compliance campaigns focused on pass-through entities. These include the Self-Employment Contributions Act campaign, the Sale of a Partnership Interest campaign, and a campaign focused on foreign investors with effectively connected income from lending transactions engaged in through a U.S. trade or business. (See also LB&I Active Campaigns | Internal Revenue Service (irs.gov) for additional information on active IRS Large Business and International compliance campaigns.) Last year, the IRS began Large Partnership Compliance audits, which focus on partnerships with assets of $10 million. Previously, the IRS focused on the largest C corporations in their Large Corporate Compliance program. Given the explosion of tax filings for pass-through entities, the introduction of a program more focused on the largest partnerships makes sense.
3. All Things International
The Tax Cuts and Jobs Act (“TCJA”) added several international provisions to the Internal Revenue Code, supporting a continued focus on all things international for corporate, partnership, and individual taxpayers.
Examinations focused on intercompany debt (whether bona fide debt or equity) are not new, and we expect continued focus given TCJA’s enactment of new IRC Sec. 163(j) and the IRS’ ability to limit interest expense deductions. Taxpayers with significant related party debt should ensure appropriate documentation is in place to report transactions for both tax and financial statement purposes and to minimize the risk that a large interest expenses deduction will be disallowed.
TCJA also enacted IRC Sec. 250, which provides a deduction with respect to foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI). For income earned by a domestic corporation through its controlled foreign corporation, IRC Sec. 250 generally provides a 50% GILTI deduction (including an IRC Sec. 78 gross-up). For income earned by a domestic corporation through its U.S.-based operations, IRC Sec. 250 generally provides a 37.5% FDII deduction. These large deductions are available until 2026, so it is reasonable to expect the IRS to spend time ensuring that taxpayers are properly computing GILTI and FDII and complying with the IRS’ substantiation requirements.
With increased funding, taxpayers should also expect continued emphasis on compliance with transfer pricing and withholding tax reporting requirements.
4. Employment Tax
With the proliferation of fraud following the COVID-19 pandemic, the IRS continues to expand its enforcement of employment tax compliance. When an employer does not deposit employment taxes that have been withheld, the IRS looks to the owners or key employees responsible for the employer’s failure to comply to collect trust fund recovery penalties from those individuals instead. With the availability of better technology and data analytics, the IRS is also able to trace funds to determine if the employer is using the payroll taxes for personal benefit. If funds intended for payroll taxes are traced to personal use, the employer could be subject to both employment tax and person income tax consequences.
During employment tax audits, the IRS may also examine the reporting of fringe benefits, the collection of Forms W-4 (Employee’s Withholding Certification) and Forms W-9 (Request for Taxpayer Identification and Certification) to determine whether withholding was properly conducted by the employer, or whether Forms 1099 were issued consistent with information reporting requirements. The IRS is also beginning to audit the employee retention credit (ERC). The IRS is verifying that employers are entitled to the ERC claimed, that it was calculated correctly and that employers have documentation to support the amounts claimed.
5. Abusive Transactions
In June, the IRS released its 2022 Dirty Dozen list. The list highlights the following four abusive transactions where taxpayers should expect enforcement activity by the IRS:
- Use of Charitable Remainder Annuity Trust (CRAT) to Eliminate Taxable Gain
- Maltese (or Other Foreign) Pension Arrangements Misusing Treaty
- Puerto Rican and Other Foreign Captive Insurance
- Monetized Installment Sales
In addition, the IRS continues to pursue syndicated conservation easements and microcaptive transactions.
To address abusive transactions going forward, the IRS recently established a new Joint Strategic Emerging Issues Team. The team brings together IRS specialists, skillsets, and tools from across the agency to identify abusive transactions, determine compliance risk, and develop a coordinated approach to addressing abusive transactions and getting people into compliance.
Our Current Issue Q3 2022: